The choice of legal ownership of a small business should be based on what?

Most new businesses start out as sole proprietorships. This is the simplest form of ownership for a sole owner and requires little more than a tax ID number. However, when there are concerns over taxation or liability issues, or when the business has multiple owners, other organization types should be considered.

Which organization type is best for your business depends on a number of factors, including the type of business it is, the number of owners it has, and the degree of concern over taxation and liability issues.

Key Takeaways

• A sole proprietorship requires little more than a tax ID.
• A partnership is an agreement to share the business revenues. Each partner's share is taxed as personal income.
• A limited liability company is a partnership that shields each partner from personal liability for debts incurred by the business.
• The C corporation is a tax entity in and of itself and can lead to double taxation.
• An S corporation passes revenues directly to the partners, who report their shares as revenue.

Partnership

A partnership is a straightforward business organization type to create. It requires an agreement that may be verbal or written.

In a partnership, the owners manage and control the business, and all revenue from it flows directly through the business to the partners, who are then taxed based on their portions of the income.

The partners are personally liable for all debts and any liabilities that result from the operation of the business.

The sole proprietorship and the partnership are the most straightforward business organization types.

When one partner leaves the business, it is dissolved unless there is an agreement in place that allows it to continue. A business continuation agreement typically stipulates the terms under which a partner can transfer a share of the business for some financial consideration.

The same agreement should provide for the transfer of a deceased partner's share so that the surviving family members receive fair compensation from the remaining partners.

Limited Liability Company (LLC)

The creation of a limited liability company (LLC) requires an operating agreement and a state filing of articles of organization.

Like the principals in a partnership, the owners of an LLC have direct management control over the company, and the company is required to file an information return to the IRS. The owners file their own individual returns based on the revenue that flows to them directly through the business. The information return shows how much revenue was paid to each partner.

The primary difference between a partnership and an LLC is that the latter is designed to separate the business assets of the company from the personal assets of the owners. That insulates the owners from personal responsibility for the debts and liabilities of the company.

In terms of the sale or transfer of the business, a business continuation agreement is needed to ensure the smooth transfer of interests when one of the owners leaves or dies.

C Corporation and S Corporation

There are two types of corporation, the S corporation and the C corporation. Both are legal entities that are formalized with the filing of articles of incorporation with the state.

The primary difference between the two is in their tax structures:

• The C corporation is a tax entity in and of itself, so it files a tax return and is taxed based on the revenues of the business. Double taxation could occur when the shareholders or owners file individual returns based on any income they receive in the form of dividends from the corporation.
• An S corporation is similar to a partnership and LLC in that it files an informational return. However, the revenue flows directly to the shareholder owners, who then file individual returns.

In most other aspects, the two business structures are the same. In both cases, the business is controlled by a board of directors which is answerable to the shareholders. The board hires the senior management team. Business assets and liabilities belong to the company, and the sale or transfer of interests can be achieved by the sale of shares.

Ultimately the type of business organization selected comes down to the owners' level of concern over management control, liability exposure, tax issues, and business transfer issues.

Because of the tax and legal implications involved, the guidance of a qualified tax attorney is essential in selecting the most suitable form of ownership.

Choosing the right legal entity for your business is a vital step in creating a startup. If you’re having trouble deciding which avenue to choose (sole proprietorship, limited liability company, co-op, etc.), we’ve compiled a comparison of each to help you decide what best suits your business goals.

Why is choosing a legal entity important?

Choosing what entity your business legally operates as is essential when you start a business because each entity has different legal and tax consequences for your business if not followed correctly. These entities offer different liability protections, which provide a degree of protection for an owner's personal assets from their business assets.

Businesses are also taxed differently depending on how they register. Corporations have more tax options than proprietorships or partnerships, though some, such as a C corporation, have double taxation—meaning their income and their shareholders’ distributions are both taxed.

Types of legal entities

Here are the five most common types of legal entities that businesses can register as. Read on to discover which is best for your business and its goals.

Sole proprietorship

A sole proprietorship is a business that is run by one person. It’s important to note that a sole proprietorship is different from an LLC owned or run by one person. A sole proprietor assumes full liability of their business for both legal and financial issues. If the business fails, the proprietor becomes burdened with all of its debt and their personal assets are at risk. As the business is operating as a single entity, sole proprietorships may be eligible for certain business tax and health insurance deductions.

Businesses are also taxed differently depending on how they register.

Partnership

A partnership is a business owned by two people. The two types are a general partnership, in which the business is shared equally, and a limited partnership, where one partner has majority control of the operations and the other contributes to and receives part of the profits. In a general partnership, each partner is personally liable for the financial and legal obligations of their partnership. However, in a limited partnership only one partner assumes the risk. The individual’s liability obligation depends on which type of partnership they are operating under. Partnerships typically do not have to pay income tax. Both partners are responsible to report their shared income or losses on their individual tax returns.

Limited liability company (LLC)

A limited liability company is a business entity that allows owners, partners or shareholders to limit their personal liabilities and have the tax flexibility of a partnership. LLCs have to be registered with the state and have a state filing fee, the cost of which depends on the state in which you're registering. LLCs protect their owners from personal liability including lawsuits, debt and other business obligations; they also have a bigger tax burden as they have to pay federal, state and local taxes, with some states requiring LLCs to pay state business tax and unemployment tax.

Corporation

Corporations are business entities that are separate from their owners and have their own legal rights. A corporation can sue, own and sell property and sell rights of ownership in the form of stocks. There are several types of corporations, including C corporations, S corporations, B corporations, closed corporations, open corporations and nonprofit corporations. The owners and stockholders of a corporation are not personally liable for any legal or financial claims against them. A corporation files its corporate taxes separately from one's personal taxes and its tax obligations depend on what kind of corporation it is registered as.

Cooperative (Co-op)

A cooperative (co-op) is a business entity that is owned by the same people that it serves. Its members or owners decide on the organization's mission, direction and profits. Like an LLC, the members of a co-op have limited liability for the legal and financial debts and obligations of the business. Co-ops do not tax their individual members on their income, only the organization as a whole.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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What will a business's choice of ownership depend on?

Depending upon the requirements of the business and the demands of the situation and sometimes even the personal preference of the owner, the choice of a form of ownership is made.

What is the most common legal form of business ownership?

The sole proprietorship is the most common form of business organization.

Which is the best legal form for a small business?

Sole Proprietorship Sole Proprietorships are the most common form of legal structure for small businesses.

What must be considered when choosing a form of ownership?

The following are some of the important factors business owners should consider when selecting a form of ownership..

Cost of Start-up. ... .

Control vs. ... .

Profits—to Share or Not to Share. ... .

Taxation. ... .

Entrepreneurial Ability. ... .

Risk Tolerance. ... .

Financing. ... .

Continuity and Transferability..